Tutorial 5

Chapter 5: The Risk and Term Structure of Interest Rates

*Bond AAA = 3 years of maturity, r =6%
*Bond BBB = 3 years of maturity, r = 10%
Why/factors?: (a) default risk, (b)liquidity, (c) information cost, and (d) tax
Question 1 consideration
Differentiate the between risk and term structure of interest rates.

Risk structure of interest rates = bonds with the same term to maturity have different
interest rates.There are several factors that influence the performance of interest rates of
bonds, which include default risk, liquidity, information cost and tax consideration.

Term structure of interest rates = the relationship among interest rates on bonds with different
terms to maturity. The default risk, liquidity, information cost and tax consideration remain the same.
Term to maturity is the same in the term structure of interest rate.
*Bond AAA = 3 years of maturity, r =6%
*Bond BBB = 5 years of maturity, r = 10%
Factors: same
Question 2
Explain the following theories of interest rates:
a. Pure expectation theory
Key assumption: *Bond AAA, 3 years, r =6%
*Bond BBB, 5 years, r = 6%
a. Long-term and short-term bonds are Perfect substitute good Bond AAA = Bond BBB
b. Market participants buy and sell bonds in order to maximize profits
c. There are no transaction costs in shifting between short and long-term bonds
It states that the interest rates on a long term bond will equal an average of short term interest
rates that people expect to occur over the life of the long term bond. If bonds with different
maturities are perfect substitutes, the expected return on these bonds must be equal.

b. Segmented market theory

Key assumption:

• Long-term and short-term bonds are NOT substitute goodBond AAA, 5 years ≠ Bond BBB, 20 years

• he forces of demand and supply in separate markets (long an short-term) will

determine the shape of the yield curves)
Bonds of different maturities are not substitutes at all, so the expected returns on holding
bond of one maturity has no effect on the demand for a bond of another maturity.
c. Preferred habitats/liquidity premium theory.
Key assumption:

• Long-term and short-term bonds are substitutes but NOT perfect substitutes. This
means that the expected return on one bond does infleuce the expected return on a
bond of a different maturity, but allows investors to prefer one bond maturity over
another,

• Market participats buy and sell bonds in order to maximize profits

• Investors tend to prefer short-term maturities (because these bonds bear less interesr-
rate risk).
It states that the interest rates on a long-term bond will equal an average of short term interest
rates expected to occur over the life of the long term bond plus a liquidity premium.
Bond AAA, 5 years, short term bond, average r = 6%
Bond BBB, 20 years, long term bond, r=6%
In general, prefer to buy short term bond (to avoid interest rate risk)
Question 3
Discuss any three (3) determinants of the risk structure of interest rate.
i) Default risk:
 Default risk occurs when the issuer of the bond is unable or unwilling to make interest
payments when promised or unable to pay off the face value when the bond matures.
 A corporation suffering big losses might be more likely to suspend interest payments
on its bonds. The default risk on its bond would therefore be quite high.
 Treasury bonds have no default risk because federal government can always increase
taxes to pay off its obligations. Bonds like this are called default-free bonds.
ii) Liquidity
o Liquidity =the relative ease with which an asset can be converted into cash
o The more liquid an asset is, the more desirable it is (holdig everything else
constant).
o Treasury bonds are the most liquid of all long term bonds because they are so
widely traded, they are the easiest to sell quickly, and the cost of selling is low.
o Corporate bonds are not liquid because fewer bonds for any one corporation are
traded; thus it can be costly to sell this bonds.
iii) Information cost
• The cost of acquiring information reduces the expected return on that financial asset
(bond).
• When information costs rise for the corporate bonds, lenders are less willing to invest
their funds in the market for that instrument at the going price and interest rate.

iv) Income tax considerations

• Interest payments on municipal bonds (MB) are exempt from federal income taxes.
• Another reason for differences in interest rates across credit market instruments is
taxation.
 • If the MBs are given tax advantage that raises their after-tax expected return relative
to Treasury bonds and makes MB more desirable.
Note: Use Figure 2 to explain the above three determinants of risk structure of interest
rate.

Question 4
Using demand for and supply of bond analysis, explain how default risk premium is determined
between a market where default risk is low and a market where default risk is high.

Low default risk refers to government bonds and high default risk refers to corporation
bonds.

 Demand and supply diagrams for the default-free (U.S Treasury) and corporate long-
term bond markets.
 Assume: initially corporate bonds have the same default risk as U.S. Treasury bonds.
 Equilibrium prices and interest rates will initially be equal (P1C = P1T and i1C = i1T),
and the risk premium on corporate bonds (i1c - i1T) will be zero
 Increase in default risk: the corporation suffer losses, the expected return on corporate
bonds decrease. So that, the demand for corporate bonds decrease, D1c to D2c .
 The equilibrium price of corporate bond falls from P1c to P2c and interest rate
on corporate bonds increase from i1c to i2c.
 At the same time the demand for treasury bonds rises from D1T to D2T .
 The equilibrium price increase from P1T to P2T P1 to P2 and the interest rates
for treasury bonds decrease from i1T to i2T.
  The spread between the interest rate on corporate and default-free bonds - risk
premium on corporate bonds-has fallen has risen from zero to i2c - i2T.
 So, we can conclude that a bond with default risk will always have a positive
risk premium, an increase in its default risk will raise the risk premium.

Question 5
Discuss four (4) basic shapes of the yield curve and four (4) uses of the yield curve.

4 basic shapes of yield curve

• Upward sloping
• Downward sloping
• Flat curve
• Inverted curve

4 uses of yield curve:

 Forecasting Interest rate
 Determining Borrowing and Lending Maturities
 Selecting Individual Securities
 Pricing New Issues

Question 6
Explain two (2) reasons why non-government bonds are likely to have higher interest rate
compared to government bonds even when they have the same maturity.

Non-government bonds = corporation bonds. 2 reasons:

• Risky
• High information cost
• Higher tax consideration
• Least liquid

Government bonds = federal bonds. 2 reasons:

• Default free
• Less risky
• Less information cost
• Most liquid
• No tax/less tax
Question 7
With the aid of supply and demand diagrams, explain why yield curve is almost always slope
upward according to the liquidity premium theory.

The theory explains fact 3 that yield curves typically slope upward by recognizing that the
liquidity premium rises with a bond’s maturity because of investors’ preferences for short-
term bonds. Even if short-term interest rates are expected to stay the same on average in the
future, long-term interest rates will be above short-term interest rates, and yield curves will
typically slope upward.

Question 8
Suppose the yield curve is downward-sloping, what is the likely effect on the business cycle?
Predict what may happen to the future short-term interest rate.

A downward sloping yield curve indicates that future short term interest rates are expected to
fall, and the economy is more likely to enter recession.